Chapter 10

Standard costs for control:

direct material and direct
labour

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 Outline
• Controlling costs
• Setting standards
• Calculating standard cost variances
• Investigating significant variances
• Cost control through assigning responsibility
• Standard costing and behaviour
• Standard costs for product costing

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 Controlling costs
• Businesses are ‘in control’ when
operations plan and achieve objectives
• Control systems provide regular
information to assist in control
• Necessary requirements for control
– A predetermined performance level
– A measure of actual performance
– A comparison between standard
performance and actual performance (cont.)

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Control systems: a thermostat
If the actual temperature rises above the preset or standard
temperature, the thermostat activates the cooling mechanism to
bring the temperature back to 22°C

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 Standard costing
• Standard costing is a part of the
budgetary control system
– A predetermined or standard cost is
developed
– The actual cost incurred in the
product process is measured
– The actual cost is compared to the
standard cost to determine a standard
cost variance

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 Standard cost variances
• Used to evaluate actual performance
and control costs
• Standard costs can be developed for
direct material, direct labour and
overheads
• When cost variances are significant the
cause of the variance must be
investigated

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 Setting standards
• A variety of methods may be used to
set cost standards
− Analysis of historical data
− Engineering methods
• Participation by managers/employees
in standard setting may lead to greater
commitment to meeting those
standards

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Analysis of historical data
• May provide a good basis for predicting
future costs
• Often need to adjust predictions to
reflect price or technological changes
• Minor changes can make historical
costs irrelevant
• Historical costs may embody past
inefficiencies

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 Engineering methods
• The focus is on what the product should
cost in the future
– How much material should be required and
how much direct labour should be used
– Time and motion studies can determine
how long each step in a production
process should take
• In practice, both historical cost analysis
and engineering methods may be used
together
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 Perfection standards
• Reflect minimum attainable costs under
nearly perfect operating conditions
– Assumes peak efficiency, the lowest material
and labour prices, the use of the best quality
materials and no production disruptions
• Motivational impact?
– Motivation to achieve lowest cost possible
– May discourage employees from working hard
as standards unlikely to be achieved
– May encourage employees to sacrifice
product quality to achieve low costs
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 Practical standards
• Practical standards are the minimum
attainable costs under normal operating
conditions
− allowances made for downtime and wastage
• Motivational impact?
– May encourage more positive attitudes
towards targets
– May encourage inefficiency and waste
– Can build continuous improvement into
standards to make them more demanding
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 Benchmarking of costs
• May involve:
– Identifying companies that have the best
cost performance
– Assessing their level of costs
– Identifying the cost performance gap
• Identifies areas needing to improve cost
performance
• Cost standards may be formulated to
achieve external performance standards
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 Direct material standards
• Standard material quantity
– The total amount of direct material
required to produce one unit of product
• Standard material price
– The total delivered cost of direct material
required to produce one unit of product
– Based on ordering a certain quality of
material in specific order quantities from a
specified supplier

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 Direct labour standards
• Standard direct labour
– The number of labour hours normally
needed to manufacture one unit of product
• Standard labour rate
– The total hourly cost of wages, including
on-costs
 On-costs are extra salary-related costs that all
companies have to pay and are usually treated
as part of the cost of labour
(cont.)

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 Direct labour standards
Actual costs for moleskin pants
R.M. Williams, September

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 Standard costs given
actual output

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 Direct material variances
• Direct material price variance
– A measure of the effect on cost of
purchasing at a price that is different
from standard
= PQ(AP – SP)
where PQ = quantity purchased
AP = actual price
SP = standard price
(cont.)

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Direct material variances (cont.)
• Direct material quantity variance
– A measure of the effect on cost of using a
different quantity of material in production
compared with the standard quantity that
should have been used
= SP(AQ – SQ)
where SP = standard price
AQ = actual quantity used
SQ = standard quantity used,
given actual output
(cont.)

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Direct material variances (cont.)
• Direct material price variance can be
calculated using the quantity of
materials used in production (AQ)
rather than the quantity of materials
purchased (PQ)
= AQ(AP – SP)
where AQ = actual quantity of material
used in production
AP = actual price
(cont.)
SP = standard price
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 Direct material price and quantity
variances, R.M. Williams

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 Direct labour variances
• Direct labour rate variance
– A measure of the effect on cost of paying a
different labour rate, compared with
standard
= AH(AR – SR)
where AH = actual hours used
AR = actual rate per hour
SR = standard rate per hour
(cont.)

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 Direct labour variances (cont.)
• Direct labour efficiency variance
– The effect on cost of using a different
number of direct labour hours, compared
with the standard hours that should have
been used for the actual production output
= SR(AH – SH)
where AH = actual hours used
SH = standard hours allowed,
given actual output
SR = standard rate per hour
(cont.)

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 Direct labour rate and efficiency
variances, R.M. Williams

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 Investigating significant
variances
• Management by exception
– Only significant cost variances are
reported and investigated
• Which variances are significant?
– Size of variance
– Recurring variances
– Trends
– Controllability of the variance (cont.)

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 Investigating significant
variances (cont.)
• Favourable and unfavourable variances
warrant similar investigation
– May reveal efficiencies and new improved
practices
– May mean that the standard is too loose
• Investigating variances may include
– Talking with managers and employees
– Writing reports to explain variances and
recommend corrective actions
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 A statistical approach to
variance investigation
• There may be many reasons for standard
cost variances
• May be caused by random fluctuations
which may not require correction
• Statistical control charts plot standard
cost variances across time and compare
them with a critical value

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Statistical control chart for direct
labour efficiency variance,
R.M. Williams, January to June

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 Costs and benefits of
investigation
• Costs include
– Time spent investigating the problem
– Disruption to the production process
– Cost of implementing corrective actions
• Benefits may include
– Reduced costs if the cause of the variance is
eliminated
– Improved work practices
• Management skills and experience allows
managers to weigh up these considerations
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 Cost control through
assigning responsibility
• Cost control is accomplished through the
efforts of individual managers and employees
• Managers are held responsible for achieving
certain cost standards
• Interactions between variances make it
difficult to assign responsibility
– Not all favourable variances are desirable
– Unfavourable variances do not always indicate a
problem
– Source of the variance may lie elsewhere

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Standard costing and behaviour
• Standards should not be set by
management accountants alone
– Not experts in areas such as material usage
and labour rates
– Managers may have better working
knowledge
– Managers controlling processes should
participate in settings standards
• Behavioural response to incentives
– Negative and positive responses
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 Standard costs for product costing
• Standard costing system
– All inventories are recorded at standard
cost
• Variances are closed off at the end of
the accounting period
– To cost of goods sold expense
– Prorate variances between work in process
inventory, finished goods inventory and cost
of goods sold

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 Flow of costs through
manufacturing accounts

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 Summary
• Standard costing systems can be
used for cost control
• Cost variances can be calculated for
direct material and direct labour
• Decision rules will guide which cost
variances need to be investigated
• Variance reporting can form part of a
responsibility accounting system
• Standard costs can be used for
external reporting purposes
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